Sunday, December 18, 2011

Companies Bill, 2011: Class Actions

In developed markets, one of the key mechanisms used for enforcement of corporate law is shareholder actions against the company or its management for breach of duties and obligations owed under law. Such shareholder actions can be either direct actions for breaches of duties owed to the shareholders directly in which case the remedies will flow to the shareholders, or they can be derivative actions where shareholders bring them on behalf of the company for breach of duties owed to the company where the remedies would flow to the company. Despite the popularity of such actions in countries such as the US, UK and several leading jurisdictions in the Commonwealth, such private shareholder actions are indeed sparsely used in India. This is evident from the fact that while shareholder suits were filed in the U.S. immediately after the Satyam scandal was revealed (and subsequently settled by the company for hundreds of millions of dollars), no significant action was initiated by the Indian shareholders who were left without any remedy for false representations in the financial statements.
In terms of shareholder remedies in India, there is a fair amount of vibrancy in direct actions in the form of claims for oppression and mismanagement brought before the Company Law Board (CLB) under sections 397 and 398 of the Companies Act, 1956. While the CLB has been active in considering these cases, their scope is fairly limited and may not necessarily be available for all instances of breaches of duties either by the company or the management. On the other hand, derivative actions, which are customarily used by shareholders to seek remedies on behalf of the company for breaches of duties by directors and senior management, are rarely utilised by shareholders in India. In a recent study to be published shortly, Professor Vikramaditya Khanna and I found that in the last sixty years only about 10 derivative actions have reached the level of the High Courts or the Supreme Court, of which only 3 have been finally allowed to be pursued. There are a number of substantive and procedural hurdles due to which shareholder derivative actions are rare in India. For example, derivative actions rely on principles of common law in the absence of a statutory provision, and they have to be brought in the normal civil courts, which are subject to delays and heavy costs that make them ineffective.
Considering some of these difficulties, the Companies Bill, 2009 introduced a specific clause on class actions by shareholders as a method to ensure greater enforcement of corporate law. However, as anticipated, this was met with stiff resistance from the industry which feared that this will lead to the opening of floodgates resulting in companies having to face numerous lawsuits from shareholders. The Government seems to have given in to the concerns expressed by the industry, and consequently a substantially whittled down provision has been introduced in the Companies Bill, 2011.
Scope of the Action
Clause 245 provides that a certain number of shareholders or depositors can bring an action before the National Company Law Tribunal (NCLT). The action can be against the company for restraining it from various acts such as those that are ultra vires the memorandum and articles of association, that are based on a resolution of shareholders obtained through suppression of material facts, or that are contrary to the provisions of the Companies Act or any other law. More importantly, a new addition in the 2011 version is that shareholders can claim damages for fraudulent actions, unlawful conduct or misstatements made by the company and its directors, and in certain cases its auditors (including the audit firm) or any expert or advisor or consultant of the company. This new provisions seems to be a result of the discourse that emanated from the Satyam episode so as to pin responsibility not only on insiders of the company but also on various gatekeepers who are responsible for ensuring compliance with the law.
Certain other provisions also support the creation of a regime for shareholder actions. For example, failure to comply with an order of the NCLT will result in a criminal offence. Moreover, the NCLT may provide that the cost of bringing the action may be defrayed by the company or other responsible person. This is a key insertion especially in derivative actions where shareholders may not have the incentive to initiate an action if they have to directly bear the cost, while the ultimate relief will flow to the company.
The Bill also provides for consolidation of similar petitions, while also specifying the manner in which the lead applicant will be chosen.
Significant checks and balances have been introduced to ensure that only genuine actions are entertained by the NCLT. First, there is a threshold limit in terms of the support required for bringing an action. The action must be supported by at least 100 shareholders, or such percentage of total number of shareholders or those holding such percentage of shares in the company as the Central Government may prescribe in the rules. Second, the NCLT is required to consider a number of factors while considering an application: whether the shareholders are acting in good faith or have any personal interest in the action, or whether the act or omission involved has been authorised or ratified by the shareholders. Third, frivolous and vexatious actions are discouraged by conferring the NCLT with the powers to impose costs on the initiating shareholders while rejecting applications on those grounds.
In sum, while it is useful that the Companies Bill expressly provides for statutory remedies in the form of class actions, it may not automatically result in greater enforcement of corporate law through increased shareholder actions. One significant advantage of the Bill is that it takes shareholder actions (such as derivative actions) outside the purview of the court and places them within the jurisdiction of the NCLT, which, due to its specialised nature, is expected to be more efficient and time-sensitive than the normal court system. However, with the imposition of significant limitations on the ability of shareholders to bring an action, it is unlikely that there will be a spate of such actions against companies. Nevertheless, the recognition of such remedies under statute will provide some relief to affected minority shareholders.


Adrian said...

Good information and very in-depth. Thanks.

Yamini said...

In USA, derivative litigation is essentially driven by the plaintiffs' lawyers and not activist shareholders. With the absence of this dynamic in India, who will have an incentive to file a derivative suit? Also, will the proposed provisions be effective enough to create a check on the actions of the directors (in the absence of the fear of being sued as frequently as would be the case where the litigation is driven by the plaintiffs’ lawyers)?

V. Umakanth said...

@ Yamini. Yes, provisions in the company law by themselves may not result in shareholder actions for breach of directors duties, unless several other associated aspects are also addressed. These are only but one step.